Two-Part TariffBundlingMonopolistic Competition10 9 8 A0 1 2 3 4 5 6 7 8 9 0 2 3 4 5 6 7 Quantity Price 1 Q1 D2 1 A2 MC QD2 10 1 Cite as: Chia-Hui Chen, course materials for 14.01 Principles of Microeconomics, Fall 2007. MIT OpenCourseWare (http://ocw.mit.edu), Massachusetts Institute of Technology. Downloaded on [DD Month YYYY]. 1 1 Two-Part Tariff 14.01 Principles of Microeconomics, Fall 2007 Chia-Hui Chen November 19, 2007 Lecture 26 Pricing and Monopolistic Competition Outline 1. Chap 11: Two-Part Tariff 2. Chap 11: Bundling 3. Chap 12: Monopolistic Competition 1 Two-Part Tariff When there are two consumers. Consumer 1 has higher demand than consumer 2. If setting P = M C, consumer 1 consumes Q1 units and consumer 2 consumer Q2 units. A1 is consumer 1’s consumer surplus, and A2 is consumer 2’s consumer surplus. Assume that 2A2 > A1. Then the maximum entry fee the firm can charge is A2. If mo re than A2 is charged, consumer 2 would not consume. Figure 1: Entry Fee of Two Consumers.Cite as: Chia-Hui Chen, course materials for 14.01 Principles of Microeconomics, Fall 2007. MIT OpenCourseWare (http://ocw.mit.edu), Massachusetts Institute of Technology. Downloaded on [DD Month YYYY]. 2 1 Two-Part Tariff Now consider the case that price is higher or lower than the ma rginal cost. • If setting P > M C, T = A2′ , we have π1 = A2 ′ + Q ′ 1 × (P − M C) = A2 + C, and π2 = A2 ′ + Q2 ′ × (P − M C) = A2 − B, thus π = π1 + π2 = 2A2 + C − B. Because C > B (see Figure 2), π > 2A2. • If setting P < M C, T = A2 ′′ we have π1 = A ′′ 2 − Q1 ′′ × (M C − P ) = A2 − D, and π2 = A ′′ 2 − Q2 ′′ × (M C − P ) = A2 − E, thus π = π1 + π2 = 2A2 − D − E. Always π < 2A2. Summary: the firm should set • usage fee P > M C, namely, larger than the marginal cost; • entry fee T = A2, namely, equal to the rema ining consumer surplus of the consumer with the smaller demand. Summary: If the demands of two co nsumers are more similar, the firm should set usage fee close to M C and higher entry fee; if the demands of two consumers are less similar, the firm should se t higher usa ge fee and lower entry fee.10 9 8 7 6 0 1 2 3 4 5 6 7 8 9 10 A’1 A’B CP MC Q’2 Q’1 2 Price5 4 3 2 1 0 Quantity 10 9 8 7 6 P Q’’2 Q’’1 D E F 5 4 A’’A’’1 3 2 MC 2 1 0 Price 0 1 2 3 4 5 6 7 8 9 10 Quantity Cite as: Chia-Hui Chen, course materials for 14.01 Principles of Microeconomics, Fall 2007. MIT OpenCourseWare (http://ocw.mit.edu), Massachusetts Institute of Technology. Downloaded on [DD Month YYYY]. 3 1 Two-Part Tariff Figure 2: Two-Part Tariff: Price Higher than Marginal Cost Figure 3: Two-Part Tariff: Price Lower than Marginal CostCite as: Chia-Hui Chen, course materials for 14.01 Principles of Microeconomics, Fall 2007. MIT OpenCourseWare (http://ocw.mit.edu), Massachusetts Institute of Technology. Downloaded on [DD Month YYYY]. 4 2 Bundling 2 Bundling Bundling means packaging two or mor e products, for example, vacation travel usually has a packaging of hotel, air fare, car rental, etc. Assume there are two goods and many consumers in the market, and the con- sumers have different reservation prices (willingness to pay). See Figure 4 and 5. The coordinates are the reservation prices of the two goods respectively. If the firm s e lls the goods sepa rately with prices P1 and P2 (see Figure 4), • when r1 > P1, and r2 > P2, the consumer will buy both good 1 and 2; • when r1 > P1, but r2 < P2, the consumer will only buy good 1; • when r2 > P2, but r1 < P1, the consumer will only buy good 2; • when r1 < P < 1, and r2 < P < 2, the consumer will buy neither good 1 nor 2. If the firm s e lls the two goods in a bundle and charges price PB , • if r1 + r2 > PB , the consumer will buy the bundle; • if r1 + r2 < PB , the consumer will not buy the bundle.10 9 r2 8 7 6 5 4 3 2 1 r1 0 0 1 2 3 4 5 6 7 8 9 10 10 9 r2 8 7 6 5 4 3 2 1 r1 0 0 1 2 3 4 5 6 7 8 9 10 Cite as: Chia-Hui Chen, course materials for 14.01 Principles of Microeconomics, Fall 2007. MIT OpenCourseWare (http://ocw.mit.edu), Massachusetts Institute of Technology. Downloaded on [DD Month YYYY]. 5 2 Bundling Figure 4: Price without Packaging. Figure 5: Price with Packaging.10 9 r2 8 7 (5,5)5 . (4,4)4 . 3 (2,2)2 . (1,1).r1 6 1 0 0 1 2 3 4 5 6 7 8 9 10 Cite as: Chia-Hui Chen, course materials for 14.01 Principles of Microeconomics, Fall 2007. MIT OpenCourseWare (http://ocw.mit.edu), Massachusetts Institute of Technology. Downloaded on [DD Month YYYY]. 6 2 Bundling Figure 6: Bundling Example 1. Bundling Example 1: the fo ur points in Figure 6 represent the four con-sumers’ res erva tion values. Consider two pricing strategies – one is that the two goods are sold separately with prices P1 = 3 and P2 = 3, and the other is that the two goods are sold in a bundle with price PB = 6. Without bundling, the revenue is R = 1 2, and with bundling, the revenue is R = 1 2; bundling does not do better. Bundling Example 2: Consider the other four consumers shown in Figure 7 and the firm chooses between the two pricing s trategies mentioned before. With-out bundling, the revenue is R = 1 2, and with bundling, the revenue is R = 2 4; obviously, bundling strategy benefits the producer in this case Conclusion: bundling works well when • the consumers are heterogeneous; • price discrimination is not possible; • the demand for different goods ar e negatively corre lated.10 0 1 2 3 4 5 6 7 8 9 10 0 1 2 3 4 5 6 7 8 9 r1 r2 . . . . (1,5) (2,4) (4,2) (5,1) Cite as: Chia-Hui Chen, course materials for 14.01 Principles of Microeconomics, Fall 2007. MIT OpenCourseWare (http://ocw.mit.edu), Massachusetts Institute of Technology. Downloaded on [DD Month YYYY]. 7 3 Monopolistic Competiti on Figure 7: Bundling Example 2. 3 Monopolistic Competition In monopolistic competition, • there are many firms; • there is free entry a nd exit; • products are differentiated but close